Sunday, October 26, 2008

Division of Power, LLC Managers v. Members

LLCs come in two basic flavors: member-managed and those managed by managers. Conflating the distinction between the two types is the fact that members may also serve as managers in an LLC that elects to be managed by managers. See Section 101(10) of the Uniform Limited Liability Company Act. Member-managed LLCs operate much as traditional partners in that management of the entity's business affairs is conducted by all the members. A manager-managed LLC operates more like a corporation with the members in the roll of shareholders / board of directors and managers as officers. Here is the general rule for business operations of a manager-managed LLC:
[A]ny matter relating to the business of the company may be exclusively decided by the manager or, if there is more than one manager, by a majority of the managers ... .
See Section 404 of the Uniform Limited Liability Company Act. I can't think of a broader formulation of manager power.

However, certain matters are reserved by the default provision of the Uniform LLC Act for decision by the members such as the admission of a new member and the consent to dissolve the company. See Section 404(c). Remember that most of the LLC Act provisions can be altered by the operating agreement. A common feature of manager-managed LLC operating agreements is to reserve for member approval purchases or contract obligations (such as leases) above a certain dollar amount. I personally advocate putting such a check on the power of the managers. For a sample, see Section 4.3 of this manager-managed operating agreement.

Friday, October 24, 2008

Admission of New LLC Members

In today's economic environment, small business is looking for additional capital. With the credit markets in turmoil, bringing in additional owners is option many shall look at. For an existing LLC, the operating agreement should address the preconditions for admission of new members. Typically, there are three drafting options for member vote necessary to admit a new memeber: (a) simple majority, (b) super majority (67%), or (c) unanimous vote. Further, it is standard for operating agreement to state that new members must consent to the terms of the existing operating agreement upon admission. What if your operating agreement fails to address the issue? Then your LLC is governed by the default LLC act provisions of the state where you were organized. Below are examples from various state laws on the admission of new LLC members where the membership interest is purchased from the LLC: What if a member wishes to sell his membership interest to a third party not currently a member of the LLC? Can this stranger walk in off the street to become a member of your LLC? This case is the sale of the member interest by an existing LLC member as opposed to the sale by the LLC itself. If we were talking about S corporations, the answer would be that only a buy-sell agreement among the shareholders could prevent the sale of stock to an outside party. In the case of LLCs, the member operating agreement can restrict the purchaser (also referred to as an assignee) from becoming a member absent consent of the other LLC members. If the LLC agreement is silent about the purchaser of an LLC interest becoming an LLC member, the default provisions of the state LLC act apply. The states are generally split between requiring unanimous or majority in interest consent of the existing LLC members.

Wednesday, October 22, 2008

LLC Member Voting

The default rule under Uniform Limited Liability Company Act Section 404 is that each member gets an equal vote. Not every state follows the uniform act on this point. California, for example, mandates that members "shall vote in proportion to their interests in current profits of the limited liability company" unless otherwise stated in the articles of organization or operating agreement. See California Corporations Code Section 17103. Florida and New York (NY LLC Act §402) also have proportional member voting. Those state I randomly checked which followed the uniform act by defaulting to per capita voting (i.e., one vote for each member) are Colorado, Illinois, and Missouri. If your state was not mentioned and wish me to look it up for you, please leave a comment.

The member voting rules given above can be modified by the LLC operating agreement. In a multi-member LLC where the member own disproportionate shares of the LLC, I have yet to find a situation where the member holding a larger share is OK with per capita voting (i.e., one person, one vote). I recommend as the best course of action to lay out the manner and power of each member in the LLC voting process. For an example, see Section 3.5 of this sample LLC operating agreement.

A final issue: Do the members have to actually meet to vote? No according to the Uniform LLC Act. See Section 401(d). However, at least one state requires unanimous written consent of the members to take action without a meeting. See Missouri Stat. Section 347.083. I suggest you check the LLC rules for your state to see what requirements there are for member voting on the issue of member action without a meeting.

Tuesday, October 21, 2008

Personal Liability for LLC Debts

It's a common question from LLC members and, in these troubled financial times, the issue shall become even bigger. The general rule for member liability upon LLC debt is set forth in the LLC act of the state where your LLC was organized. California's Corporate Code Section 17101 is typical of what one finds in other states.
Except as otherwise provided in Section 17254 or in subdivision (e), no member of a limited liability company shall be personally liable under any judgment of a court, or in any other manner, for any debt, obligation, or liability of the limited liability company, whether that liability or obligation arises in contract, tort, or otherwise, solely by reason of being a member of the limited liability company.
I've reproduced just subdivision (a) of section 17101. Subdivision (e) basically states that the general rule of no member personal liability found in (a) is inapplicable where the member cosigns or guarantees an LLC debt. A new small business entity, whether it be an LLC or Sub S corporation, has by its nature zero credit history. As such, the owners invariably are asked to cosign business contracts such real estate leases, bank lines of credit, credit card accounts, equipment leases, and phone service contracts. Even if your LLC has been in business for a number of years, you as a founding member could still be liable for LLC debts from these sorts of accounts that were set up years ago but for which you cosigned. If your LLC is in danger of going under and you are concerned about personal liability, check the contracts with the lenders / suppliers. I've seen instances where the members cosigned on a contract exposing themselves to personal liability without even realizing they had done so.

Sections 17254 and 17255
California does not give titles to their statutes. If they did, Section 17254 would be named "Liability for unlawful distributions". See Section 407 of the Uniform Limited Liability Act. Essentially, Sections 17254 and 17255 make a member who votes for distributions to the members personally liable where said distribution will leave the LLC unable to pay its debts or with liabilities in excess of assets. The comments to Uniform LLC Section 407 state: "The recovery remedy under this section extends only to the company, not the company's creditors." California section 17254 is close to the model provision but not exactly the same. I'm uncertain whether a creditor may attempt to use Section 17254 to force personal liability upon members who have violated its provisions. Under the model act, only the LLC could make a claim against a member for violation of Section 407. Be that as it may, creditors also have resort to the Uniform Fraudulent Conveyances Act for transfers made at a time when a debtor is insolvent for less than full and fair consideration.

In light of these provisions, members need to be very careful about making distributions from the LLC to themselves when the LLC could be considered insolvent or otherwise unable to pay its debts.

Monday, October 20, 2008

Removal of Member From A Texas LLC

I answer questions on business law and estate planning topics over at my commercial web site and thought I would post some of those Q&As here to give them wider circulation.

"I read Sec 101.107 of TX LLC Act, however one of the members deserted (literally walked out one night and has not returned) the business almost a year ago, and actually has worked with competitors as an advisor... What applies here? Cathy."

Section 101.107 prevents the withdrawal or expulsion of a member in a Texas LLC. However, as explained in this prior post, I believe the Texas LLC Act allows the members to modify Section 101.107 through their operating agreement. I assume you wish to kick out the member now working for a competitor. If your operating agreement contains a mechanism for terminating or removing a member, then then it overrides § 101.107. As your question makes no mention of an operating agreement, I assume your LLC either does not have one or it is silent on removal of a member.

Question: what is the legal consequence of a member working for a competitor of the LLC absent any bar to such activity in the LLC operating agreement? I'm not sure because the Texas LLC Act does not spell out what if any duty of loyalty LLC members owe to each other. At least one Texas lawyer believes it is likely that members of a member-managed LLC owe a fiduciary duty of loyalty to the LLC and to the other members of the LLCs. I concur with that view. See also prior blog post on this topic. Thus, under this view, the member who went AWOL then consulted with the competition has violated this duty of loyalty to the other members. This may give rise to a cause of action for damages and/or injunctive relief. The best course of action would be to retain a local attorney for assistance in this matter. A claim against the departed LLC member for violation of the fiduciary duty of loyalty may bring him or her to the bargaining table to negotiate a withdrawal from the LLC (which is probably what you desire).

Wednesday, October 15, 2008

Planning for bankruptcy of an LLC member

These are tough economic times. Entering into a business relationship with another individual is much like a marriage, for better or for worse. However, in the business relationship, one is allowed to take precautions against "the worse". What happens when one member of a multi-member LLC goes bankrupt? Absent some provision in the operating agreement to the contrary, the member's LLC ownership interest becomes the property of the debtor's bankruptcy estate. Does the debtor still have the authority to act on behalf of the LLC as a member? Unless the operating agreement addresses this issue, the answer depends on which state your LLC is organized in. Some states such as Florida have a specific statute in their LLC code stating that a person ceases to be a member upon filing for bankruptcy. See Florida Stat. § 608.4237 and Uniform Limited Liability Company Act § 601(7).

How does this effect drafting of LLC operating agreements? As not all state LLC acts, to my knowledge, automatically terminate a member's right to vote and participate in the management of an LLC when filing a petition in bankruptcy, it is prudent to write such a provision into the operating agreement. But see below caveat. If the member becomes disassociate, the next issue is what does that member receive in return for his or her membership interest upon disassociation? One turns first to the operating agreement to see if this is spelled out and, if not, then the default provision of the state LLC act control. Using Florida as an example again, I believe Florida Stat. § 608.427 speaks to this situation even though it uses the words "withdraw" of a member rather than ceasing to be a member by operation of law. Section 608.427 states that the withdrawing member receives "the fair value of the withdrawing member's interest". Trust me, that's nearly impossible to calculate in closely held, small business LLCs. There is no market for small business LLC interests so basically one is left with hiring accountants to pull numbers out of their ass, which often leads to litigation. Thus, the smart move is to set forth in the operating agreement exactly what the disassociated member receive upon filing for bankruptcy. Examples include the member's capital account, some multiple of past earnings of the LLC then multiplied by the member's ownership percentage, book value of the LLC multiplied by the member's ownership interest, or naming a specific outside expert to value the departing member's interest if agreement cannot be reached. These examples require the LLC to come up with capital to pay off the departing member in a reasonably short time frame. That may place a burden on the LLC. Another option is for the disassociate member to be stripped of management and voting power within the LLC but to retain all rights to distributions otherwise payable to his or her ownership interest.

As with everything in the law, exception apply. What about a professional service LLC or one whether a significant chunk of the LLC is tied to specific members? It may not be in the best interest of the LLC as a whole to automatically expel a member generating significant revenue for the LLC upon the filing a petition for bankruptcy. In such case, perhaps the prudent course is to suspend the member's voting rights during bankruptcy and, further, limit the bankrupt member's ownership rights to those of an assign (i.e., retains right receive distributions otherwise payable to the LLC ownership interest).

Sunday, October 12, 2008

Do I need a lawyer to set up my LLC?

The correct answer is "that depends". Everyone prefers a straight up 'yes' or 'no', unfortunately, our laws come in shades of gray. Legal formation of an LLC is a relatively simple matter. The steps are outlined here. Or, if you prefer, there are services with reasonable prices that do LLC formation. Check out the ads on this Google query for a sample of incorporation companies. (One cavaet for Arizona, this state requires publication of notice of formation of the LLC.) For single member LLCs, one small but important item to keep in mind for single member LLCs comes when filling out IRS Form SS4 to obtain your federal employer identification number. For question 9a entitled "Type of Entity", check the first box "Sole Proprietorship" and give your personal Social Security Number. Why? This allows your LLC to be disregarded for federal tax purposes and, thus, removes the need to file a separate federal tax return for the LLC. Instead, the single owner of the LLC reports income / loss from the LLC on Schedule C of his or her personal IRS form 1040. If you don't know what I'm talking about, please consult with your tax accountant.

So you formed the LLC through the state and obtained an IRS tax identification number, what is left? For single member LLCs, maybe nothing. The last step is execution of an operating agreement. To my knowledge, only the state of Missouri requires all LLCs to have an operating agreement. See Mo. Stat. § 347.081. 1. Even outside of Missouri, it is common for single member LLCs to have operating agreements. Why should the sole member of an LLC have an agreement with himself? Typically banks and other financial institutions require LLCs to supply an operating agreement before they will allow the LLC to open an account. In the majority of states, this is the only document which positively lists all the current member of the LLC and their voting power within the LLC. If you are a single member LLC and the bank wants an operating agreement, any standard vanilla operating agreement form shall suffice IMHO. It's not necessary to pay an attorney $500, $1000 or more in these cases. Here is a link to the® LLC operating agreement. This document is created online by filling out a relatively simple questionnaire.

All LLCs with more than one member absolutely should have an LLC operating agreement. Don't rely on an oral agreement to delineate ownership interest, how the profits are to be split, what work each members shall perform for the LLC, capital contributions, the right to withdraw from the LLC, etc. Take the time to reach agreement on all of these issues among the members prior to launching your LLC. Is it necessary to get a lawyer to draft an LLC operating agreement? These can be complicated documents so it is recommended. Using a lawyer means you get a document that a lawyer is willing to stand behind as something suited to your needs containing language that has been explained to you. Downloading a legal form from the internet is quicker and much cheaper but comes with the risk that the document purchased does not do all you desire, that you don't really understand the provisions of the contract, or that there was some error in drafting. If your choice is download an LLC operating agreement from the internet or fail to have one at all, I would go with the online document. Check to make sure the company has been in operation for more than a few years, that the form templates were drafted by lawyers, and also whether any complaints have been filed against the seller with the BBB.